Question

Based on Modigliani and Miller's Propositions I and II in a perfect world without taxes nor distress costs, if the original unlevered firm value is $100 million and the CFO is planning to carry out a leveraged recapitalization to a debt equity ratio of 1:2. What’s the levered firm value? If the unlevered equity requires 11% annual return and the debt requires a 5% of annual return, what’s the required return for the levered equity? Please show all steps and equations.

Answer 1

Answer:

Consider the following calculations

Explanation:

Value of levered firm = Value of unlevered firm + debt*tax rate

As tax rate = 0

Value of levered firm = Value of unlevered firm =100m

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 11+0.5*(11-5)*(1-0)

Levered cost of equity = 14